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Sunday, September 14, 2014

It's Hard To Ignore George Soros' SPY Put Position Anymore

George Soros is a multi-billionaire hedge fund manager. He is perhaps most famous for his role in the Quantum Fund - a fund he established in 1969. A $1000 investment then would have made you $4 million by 2000. This fund has been one of the most successful hedge funds in history, and George Soros has the consequent reputation as a pre-eminent money manager.

On August 15, 2014, MarketWatch reported that Soros Fund Management had increased its put position on the S&P 500 (NYSEARCA:SPY) from 1.28% of its holdings to 4.79% in Q1 2014. It had then roughly tripled that in Q2 2014 to 13.54% of its holdings. According to Whalewisdom.com, Soros' put position in the SPDR S&P 500 ETF amounted to 16.6513% (about $2.21B) of his total portfolio value of $13.27B as of June 30, 2014. It is Soros' top portfolio holding. George Soros doesn't usually make bets this big on a whim and he has historically been correct on a lot of his big bets. Investors should consider following his example. Such a bet would provide a hedge against a large downside move by the US equities market, which many are increasingly worried is coming.

Back to the main topic. Soros seems to be sure that the S&P 500 will eventually fall dramatically. His actions have been a doubling down at each new interval recently. Will this mean he is definitely right? No one could say that for sure. However, the S&P 500 has not had a strong pullback since July 18, 2011-August 15, 2011. The bull market has been in effect since early March 2009. That's about 66 months. The average length of a bull market since 1871 has been 67 months. The median length has been only 50 months. We are starting to become very overdue for a bear market. The median bear market drops about 38% in roughly two years. Soros may be planning on this. He may be planning on just a strong pullback, which also seems overdue.

Soros may also play both of the above possibilities. That is, he may take some profits if he gets a strong pullback before he gets a bear market. For instance, many pundits feel that we are overdue for a strong pullback; that could occur almost immediately. However, many feel that a bear market will not start until after the midterm elections. They feel that the politicians will not allow that. After the midterm elections, there would likely be the Christmas rally. That is something that has been historically hard to stop. Then, there is typically a small cap rally in January. However, if the overall market performs poorly in January, that often signals a bad year. Such a signal could easily be the start of the bear market that is increasingly overdue. It is easy to see Soros' logic. It may be wise to hedge the market to the short side along with him at this point. Besides you would be getting short at a point where he has already doubled down twice. Your odds of success should then be better than his.

I am suggesting following Soros, but it is not just his reputation or just the long in the tooth bull market that makes me think he may turn out to be right. The following are further indicators that we may see a negative turn in the market soon:

1. The margin debt level for the NYSE is incredibly high. When the selling starts, there may be a huge rush to the door and prices may overshoot to the downside due to the large amount of fear that the rush to the exit engenders (see chart below).

2. As investors can see, the large negative credit balances have marked the ends of the previous two bull markets rather dramatically. The current negative credit balance is notably bigger than either that of the tech bubble or that of the pre-Great Recession bubble. We may see a dramatic fall. I'm sure Soros has seen this chart or one like it.

3. The CAPE (Cyclically Adjusted PE) for the S&P 500 is abnormally high at 26.27 as of September 12, 2014. The mean is 16.55 and the median is 15.93, so the current reading is significantly higher than normal. This indicates that the S&P 500 is over priced. It needs to sell off for many investors to think they are getting a bargain when they buy.

4. The US GDP growth rate for Q2 2014 was 4.2%; but for Q1 2014, it was only -2.1%. This averages out to a weak GDP growth for 1H 2014 of +1.05%. Many expect growth in 2H to be as high or higher than the Q2 2014 growth, but the Trading Economics figures are lower than that at +3.0% for Q3 2014 and +2.8% for Q4 2014. Further these are just forecasts. The actual numbers could easily underperform (or outperform) the forecasts.

5. Russia is in a recession, according to the IMF, and the increasing sanctions by the EU and the US over the situation in the Ukraine are only likely to make that recession worse. Further Russian retaliatory sanctions against the US and the EU are bound to hurt both of those economies as well.

6. The final Chinese HSBC/Markit Purchasing Managers' Index (PMI) fell to 50.2 in August 2014. This is almost to the contraction point of less than 50.0. The August Chinese PPI was -1.2% year over year. This was slightly worse than expected and a negative value is usually interpreted as a sign of a slowing economy. Reinforcing this thesis was the Chinese Industrial Production year-over-year gain of only 6.9% for July 2014 compared to the previous month's 9.0% gain. The Foreign Direct Investment year over year for July was also down -0.4% - the first fall in 17 months.

7. If China's economy slows too much, there is the very real possibility of a massive credit crisis in China. I have seen estimates for bad debts as high as $4T; but they may be much more. For instance, one report issued by the National Audit Office December 30, 2013 said that just the borrowing by provinces, counties, and townships reached roughly $3T as of June 2013. This was up 63% since the end of 2010 and it has surely gone up more since June 2013. Much of the Chinese "local government debt" is bad debt already. They have no way of paying it back. On top of this debt, there is the national debt, the business debts, and debts of individuals. The more the economy slows, the more debt will go bad. My estimate is that a critical level may be the 5%-6% GDP growth range for China. Chinese GDP growth was 7.5% in Q2 2014, which is still far above that. However, it is wise to remember that Chinese GDP growth was 10.4% in 2010 and it was over 10% for many of the years from 2003-2010. This allowed credit based on a 10%+ growth level to build up considerably, and China may be in for a severe credit crisis as its economy continues to slow. Plus don't forget it is the world's second largest economy. It is no longer some small isolated economy that the US can ignore.

8. The trouble in the Ukraine seems to be escalating rather than abating. Israel is having trouble with the Palestinians again. Iraq is in a state of Civil War, and Obama is now overtly helping the sitting Iraqi government with US air power. Many are starting to carp that he is starting a new war without Congressional approval. This is a bit of a fuzzy area for the moment. However, over the longer term, Obama probably needs Congressional approval and it is not clear he will get it. What will happen then? The uncertainty of this situation, even more than the possibility of another US war in Iraq (and possibly Syria), could derail the bull market.

10. Brazil may be in a new recession. Its GDP shrank -0.6% in Q2 2014, and its Q1 GDP growth was revised downward to -0.2%.

11. Italy is in recession again; and the 18-country Euro Area GDP growth was flat at 0.0% for Q2 2014. Portugal's Banco Espirito Santo needed a 4.9B Euro bailout. Austria's largest bank, Erste Bank, saw its stock crash after it revealed a 40% surge in bad debt provisions, which led to a -$2.2B loss. The IMF thinks Europe's financial sector has $2T in bad debt on its books, so there is probably a lot more bad news to come. Draghi's recent QE moves would seem to confirm this thesis. Then there are the roughly 25% unemployment rates in both Greece and Spain. Plus, youth unemployment in Europe is greater than 50% in Spain and Greece, and it is over 40% in Italy and Croatia. The overall picture is ugly; and the sanctions by Russia can seemingly only lead the EU further down the rabbit hole. If the EU economy goes into another recession, which it seems close to doing, that will in turn have negative effects on the US and Chinese economies.

12. There are many more economic data points that I have left out, but the above ought to be enough to give readers an idea of the perils of the current world economic situation. The above does not mean that the sky is falling. However, it does mean that investors need to keep a close eye on the world economic situation. It could deteriorate easily; and if it does, we could be in for some very hard times.

All told, the rationale behind Soros' bet on a down move in the S&P 500 seems sound. That doesn't mean we will get one immediately or even with the new year. However, it probably does mean that investors may want to start to hedge their portfolios as Soros is doing. If you decide to do so, keep in mind that he still has only 16.6513% of his portfolio in this negative bet as of June 30, 2014. It may be roughly $2.2B, but that is only because Soros manages a lot of money. Consider also that Soros may be averaging into his position. He has already doubled down twice. Meanwhile, the S&P 500 is up 8.86% for 2014 through the market close on Friday September 12, 2014. He has lost money on this bet thus far, but he is a seasoned investor. He does not believe he can time the market perfectly. Investors who decide to follow his strategy should keep in mind that they likely cannot time the market perfectly either. Their strategies should recognize that reality. Any put position should be long dated.

If you consider that a bear market is usually a 2+ year event, you should be able to find an appropriate strategy for you. A 38% fall from the recent SPY closing high of $201.11 would be to $124.69 per unit of the SPY ETF. If you don't believe this large a fall will occur, you can bet on a lesser fall. For instance, the SPY January 2016 $195 put options are $14.62. They would become profitable at any price below roughly $180. If you did a put spread, you might use $180 as the bottom. You could sell these $180 puts for $9.50, or you could sell the $170.00 puts for $6.98, etc. (to partner with the $195 puts you bought). The spread would cost you less than simply buying the $195 January 2016 puts, but it would also limit your profits.

Some people will just want to short the SPY ETF itself, but investors should keep in mind that they must pay the dividends (about 1.78% annually) on any SPY units that they are short. Plus, you will be losing money for all of the distance the SPY goes up. If you are sure of a downturn, this is not a huge issue. However, remember the old adage, "the stock market can stay irrational longer than you can stay solvent." With options your risk is at least defined. This is one reason some investors such as Soros prefer to use puts. Further, the options control many more shares with much less money. That allows Soros to still bet many things to the upside, while using options as downside protection.